Financial statements are used by analysts, investors and bankers to learn more about the financial status of a company. These statements are based on accounting conventions that provide guidelines for recording and recognizing assets, liabilities, sales and expenses. Due to the difference between the fiscal year and the tax year, small businesses often have a discrepancy between what's reported on financial statements and what's reported to the Internal Revenue Service. Accountants turn to GAAP -- generally accepted accounting principles -- guidance on accounting treatment for both inventory and depreciation.
Inventory valuation can change the way both the balance sheet and income statement are reported. Companies can report a higher or lower net income based solely on the reporting standard used. The IRS does not allow a company to use one inventory valuation method for financial reporting and another for tax purposes, so it's important to select the best method for your organization. The three main accounting standards for valuing inventory are last-in, first-out, or LIFO; first-in, first-out, or FIFO; and average cost.
LIFO assumes the most recent inventory purchased is the first to be sold. In periods of rising costs, LIFO values the cost of goods sold higher than the inventory on the books. This results in lower net income and higher asset value on the balance sheet. FIFO assumes the most recent inventory purchased is the last to be sold. In periods of rising costs, FIFO values the costs of goods sold lower than the inventory on the books, which results in higher net income and lower asset value on the balance sheet. The average cost method uses a weighted average to value inventory on the books.
Like inventory valuation, the methodology used to estimate depreciation can change the value of assets on the balance sheet and the calculation of net income on the income statement. Unlike inventory, depreciation is a non-cash expense; that is, no cash exchanges hands. The main purpose of depreciation as an accounting convention is to maintain the integrity of the balance sheet by writing off a certain portion of an asset's value as it is used over time. There are three primary ways to estimate depreciation: the straight-line method, the accelerated method and the Modified Accelerated Cost Recovery System, or MACRS, which is an accounting standard provided by the IRS.
Straight-line depreciation is calculated by subtracting the salvage value of an asset from the purchase price and then dividing by the useful life of the asset. The accelerated method of depreciation is a multiple of straight-line depreciation. If straight-line depreciation is calculated at $100, accelerated depreciation may be calculated as $200. Accelerated depreciation is used to depreciate assets that lose value faster in the beginning of their useful life. IRS Publication 946 provides guidance on the Modified Accelerated Cost Recovery System.
